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For much of the past decade, US power supply increasingly exceeded demand, putting downward pressure on power prices across the country and threatening the economic viability of power plants in deregulated markets. Beginning in 2018 and projecting beyond, the power industry’s supply-and-demand profile is likely to change, especially in places such as Texas—driving better pricing power as old power plants retire and demand continues to grow. This dynamic should generally lead to improved earnings and better-than-expected cash flow for surviving power generation companies.

During the past decade, reserve margins—the additional power capacity available to meet demand during high-demand periods—were amply supplied. Peak power load, the amount of electricity required to prevent a wide-scale power outage, generally exceeded the standard 15% rate. While some coal-powered plants were closed due to stricter federal environmental standards aimed at reducing air pollutants, new gas-fired power plants and an increase in renewable energy sources (e.g., wind power production) largely offset the reduction in coal-fired power capacity. As a result, the US power market remained well oversupplied, and power prices fell into a multiyear decline from 2008 until hitting bottom in 2016.

More recently, there have been signs that supply-and-demand conditions within the US power markets have begun to shift. Lower power prices have driven down the profit margins for coal and nuclear plants to the point where more plants have closed, some new power plants have struggled economically, and the planned production of other new gas-fired plants has come to a halt.

Nowhere is this trend more apparent than in Texas, 1 of the 2 major power pools in the US, where the Electric Reliability Council of Texas (ERCOT) manages the flow of electric power to 24 million customers, representing 90% of the state’s electric load. Texas is one of the few power markets with substantial power-demand growth, due to above-average economic and industrial growth, driven mainly from energy and chemical companies with operations along the Gulf of Mexico. At the same time, due to the economic pressures from the resulting power oversupply, new combined-cycle gas turbine (CCGT) plants—which use a gas and steam turbine—have been put on hold, and coal- and gas-fired plants are being retired.*

As power capacity declines in Texas, the gap between peak load and capacity is expected to close, which should support increased power prices.

E = estimate. Peak power load is a metric for demand; the amount of electricity required to prevent a wide-scale power outage. Power capacity is the amount of electricity available to meet demand. Source: Report on the Capacity, Demand and Reserves (CDR) in the ERCOT Region (2017-2026), as of December 15, 2016, ERCOT.com.

In sum, these plant closings are accelerating supply rationalization in Texas, solidifying our conviction that not only will power supply and demand tighten in 2018 and beyond, but this contraction will occur more quickly than the market is anticipating (see chart). Further, if there is severe weather in the summer, combined with outages—such as extended heat waves that stress older plants—that gap could tighten even faster. As Texas regains a more balanced supply-and-demand ratio, we expect other markets will quickly follow, benefiting those surviving power generation companies that exhibit solid business fundamentals.

Next steps to consider

* For example, in a surprising move in mid-October, Texas-based Vistra Energy, the state’s largest provider of electricity and natural gas, announced the retirement of two coal-fired plants, taking 2,300 mega-watts (MW) of coal capacity off-line, citing a lack of economic viability for these plants. This announcement came just one week after the company stated it was closing its three-unit 1,800-MW coal plant. In Texas’s market of 81,000 MW in supply, these decisions resulted in 5% of the state’s power supply being removed in just two weeks. Vistra also has plans to close additional plants by 2020, due to marginal economics, inefficiency and/or high pollution levels—all helping to narrow the power supply and demand gap and bolster the company’s bottom line.

Douglas Simmons is a portfolio manager for Fidelity Investments. Mr. Simmons currently manages several utilities sector portfolios and subportfolios, and serves as co-manager of diversified equity portfolios. Mr. Simmons joined Fidelity in 2003, covering the environmental sector, as well as electric and gas utilities.

Views expressed are as of December 1, 2017, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.

The utilities industries can be significantly affected by government regulation, financing difficulties, supply and demand for services or fuel, and natural resource conservation.

1. About 10% of total U.S. energy consumption was from renewable energy sources in 2015. More than half of U.S. renewable energy is used for producing electricity, and about 13% of U.S. electricity generation was from renewable energy sources in 2015. Source: U.S. Energy Information Administration.

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